Another significant difference between the two types of multifamily properties is how they are valued. Residential properties (2-4 units) are valued the same way single family homes are – based on comparable sales. Lenders will be looking at the income of the property but that doesn’t impact the value. On the opposite end of the spectrum, with apartments, the value of the property is based on the Net Operating Income of the property divided by the market cap rate. That means that the more net income the property is producing, the more it will be worth to a buyer. So, what do these differences mean for you? Well, nothing really. But it’s important to know the game you’re preparing to play. If you are more conservative in nature, I’d venture to say that starting in residential multi-family real estate (2-4 units) will provide a nice steppingstone to allow you to get to know multifamily. You will use the experience you’ve already gained through your single family home investing but with the benefit of having more units and more cash flow. Not much else is different.
Small multifamily is going to be very similar to what you already know. Why is that? Properties that are 1-4 units are considered “residential” for the purpose of financing. When lending money, most banks will look first at the borrower and secondly at the property. This means they want to make sure you make enough money to pay for all of the expenses of the property plus the mortgage payment if all of your rents don’t come in. Apartment buildings (5+ units) are considered “commercial” for the purpose of financing. When lending money, banks will look first at the property and how it performs. They will want to see that regardless of your existence, the property pays for itself and then some. For example, there is something called Debt Service Coverage Ratio (DSCR). If a bank has a minimum DSCR of 1.25, they’ll want to see that the Net Operating Income (income minus operating expenses) is at least 1.25 times the debt service (principal and interest payment). That is their primary concern. The borrower is secondary, and make no mistake, they’re still looking at you, but they’re not qualifying the property based on how much YOU make. It’s based on how much money the property makes.
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